Friday, April 22, 2011

Oil Price Spikes and Excess Volatility: Investors Always Welcome

Financial markets have always been subject to erratic swings in prices due to investor whims, notions, and panics. Commodities markets -- including oil markets -- have become more like equity markets in that jittery respect. Fast and powerful electronic trading platforms combined with a delusional mindset that says oil will always go up in price, biases oil markets in the upward direction. Particularly when the global economy is stuck in a stagnant funk thanks to generally dysfunctional policies of central banks and governments -- and big institutional investors are desperate for ways to increase portfolio asset value.

...supply, demand and geopolitical risks are no longer reliable tools for predicting commodity prices, and haven’t been since the early 2000s. At that time, two major trends converged and altered financial and commodity markets.

First, the advent of widespread Internet trading platforms radically increased the number of people with access to commodity markets, decreased the amount of time it took for an investment decision to impact the market and expanded the amount of money that could be applied to those markets. In particular, the creation of energy-indexed investment vehicles created additional demand for commodities by people who have no intention of ever taking delivery of the commodity.

Second, this technological evolution occurred just as America’s Baby Boomers, the largest generation in American history as a proportion of the population, approached retirement. For the most part, their children had moved away and their homes were paid for, while their earning power was the highest in their lives. Consequently, this demographic had large savings, and over the last 10 years those savings have become available for investment just as more options for investing it into commodities have opened up. Most of the developed world has a similar demographic bulge.

This created a problem for predicting prices. Industrial demand is fairly easy to predict, since it is based on — and highly constrained by — actual structural realities. If one has a good feel for an economy, one can reasonably predict whether economic activity is rising or falling and how industrial firms will react to that.

Not so with investors, who — almost by definition — trade on intuition as they seek to outthink the markets and each other. But perhaps most important, unlike the industrial world, the world of investors has no single or collective pulse to take. Even if there were, investors often respond to price shifts in a manner opposite to industrial players. Rising prices draw them rather than scare them away. After all, no investor wants to miss out on a winning trend. And so those investors have become the oil market’s price setters.

In any other market, the presence of a mass of new players would obviously have a distorting effect, but in the oil market, the inelastic nature of oil demand magnifies the investor presence. Since oil is so essential to modern life — needed for everything from transportation to making plastics, fertilizer or paint — industrial and retail demand for oil is actually fairly stable. The introduction of dynamic actors into a normally static system results in periodic and disproportionate price shifts....

...investors make the system sufficiently erratic that forecasting its activity, aside from noting that price crashes are inevitable, is largely impossible.

There is one final factor in play that is driving the markets, and in the past five years it has greatly magnified the role that investors play: an increase in the money supply.

Over the past six years, the global money supply has roughly doubled. There are any number of reasons to expand money supply, but the most relevant ones of late have been to ensure that there is sufficient credit to stabilize the financial system. However, governments have few means of forcing such monies to go in any particular direction. And since the entire purpose of professional investors is to shuffle money to where it will earn them the highest return, some of the money from an expanded money supply often finds its way into commodity markets. _Forbes

Conventional wisdom has long proclaimed that out of control futures markets cannot affect the real price of a commodity. In the distant past, that was approximately true. But modern traders have more sophisticated tricks up their sleeves than you would believe. And the largest of them are quite well connected with the political power structures in any advanced nation with significant financial markets.

Popular delusions of "peak oil" and "climate catastrophe" can only aggravate political and economic forces at the highest levels, leading to stacked dysfunction and snowballing misallocation in government policies and financial strategies.

Wildly fluctuating energy costs and periodic commodities crashes are nuisances, to be sure, and often impossible to ignore. Nevertheless, in terms of personal and group planning, it is best to treat such movements as distractions -- unless you have special insights into the particular swings that are taking place moment by moment on the global stage.

But beware. Almost everything you think you know, is wrong. Well, actually, everything you think you know is wrong, but I wanted to leave you with at least a little hope. ;-)